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Chapter 13. Market Efficiency

The document discusses the efficient market hypothesis (EMH) which states that current stock prices fully reflect all available public information. It defines three forms of market efficiency - weak, semi-strong, and strong - based on the types of information reflected in prices. The weak form suggests prices reflect only historical price data, semi-strong reflects both historical data and public news/reports, and strong form reflects all public and private information. Evidence supports at least weak and semi-strong forms of efficiency. If markets are efficient, it has implications for financial managers like the timing of stock issues not providing advantages. Fundamental and technical analysis approaches to valuation are also discussed.

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Hastings Kapala
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87 views3 pages

Chapter 13. Market Efficiency

The document discusses the efficient market hypothesis (EMH) which states that current stock prices fully reflect all available public information. It defines three forms of market efficiency - weak, semi-strong, and strong - based on the types of information reflected in prices. The weak form suggests prices reflect only historical price data, semi-strong reflects both historical data and public news/reports, and strong form reflects all public and private information. Evidence supports at least weak and semi-strong forms of efficiency. If markets are efficient, it has implications for financial managers like the timing of stock issues not providing advantages. Fundamental and technical analysis approaches to valuation are also discussed.

Uploaded by

Hastings Kapala
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Chapter 13

Efficient market
Hypothesis
EFFICIENT MARKET HYPOTHESIS
Definitions of market efficiency
(a) Allocative efficiency
If financial markets allow funds to be directed towards firms which make the most productive use of them, then there an
allocative efficiency in these markets.

(b) Operational efficiency


Transaction costs are incurred by participants in financial markets, eg commissions on share transactions, margins between
interest rates for lending and for borrowing, and loan arrangement fees. Financial markets have operational efficiency if
transaction costs are kept as low as possible. Transaction costs are kept low where there is open competition between brokers and
other market participants.

(c) Information processing efficiency


The information processing efficiency of a stock market means the ability of a stock market to price stocks and shares fairly and
quickly. An efficient market in this sense is one in which the market prices of all securities reflect all the available information

Degree or forms of efficiency


For the purpose of testing, EMH is usually broken down into three forms as follows:

1. The weak form


Weak form hypothesis states that current share prices reflect all relevant information about the past price movements and their
implications. If this is true, then it should be impossible to predict future share price movements from historic information or
pattern.

Share prices only changes when new information about a company and its profits has become available. Since new information
arrives unexpectedly, changes in share price should occur in a random fashion; hence weak form can be referred to as random
walk hypothesis.

2. Semi – strong form


Semi –strong form hypothesis states that current share prices reflect both
(i) All relevant information about past price movements and their implications;
‘and
(ii) Publicly available information about the economy.
Any new publicly available information whether comments in the financial press, annual reports or brokers investment advisory
services, should be accurately and immediately reflected in the current share price, so investment strategies based on such public
information should not enable the investor to earn abnormal profit because these would have already been discounted by the
market.

3. Strong form
The strong form hypothesis states that the current share prices reflect all relevant information available from
 Past price changes
 Public knowledge; and
 Insider knowledge available to specialists or experts such as investment managers.

Market efficiency Page 1


Features of efficient markets
 The prices of securities traded in that market reflect all the relevant information accurately and rapidly, and are available to
both buyers and sellers.
 No individual dominates the market.
 Trading costs of buying and selling are not so high as to discourage trading significantly.
 Market efficiency from the perspective of the EMH relates to the efficiency of the information, the better the information
received by the investors, the better and the more informed the decisions they make will be.

Impact of efficiency on markets


If the stock market is efficient, share prices should vary in a rational way.
a) If a company makes an investment with a positive NPV, shareholders will get to know about it and the market price of its
shares will rise in anticipation of future dividend increases.

b) If a company makes a bad investment, shareholders will find out and so the price of its shares will fall
c) If interest rates rise, shareholders will want a higher return from their investments, so market prices will fall.

Implications of EMH for financial managers


If capital markets are efficient, the main implications for financial managers are;
1. The timing of issues of debt or equity is not critical, as the prices quoted in the market are ‘fair’. That is price will always
reflect the true worth of the company, no over or under valuation at any point.

2. An entity cannot mislead the markets by adopting creative accounting techniques.

3. The entity’s share price will reflect the net present value of its future cash flows, so managers must only ensure that all
investments are expected to exceed the company’s cost of capital.

4. Large quantities of new shares can be sold without depressing the share price.

5. The market will decide what level of return it requires for the risk involved in making an investment in the company. It is
pointless for the company to try to change the market’s view by issuing different types of capital instruments.

6. Mergers and takeovers. If shares are correctly priced this means that the rationale behind mergers and takeovers may be
questioned. It companies are acquired at their current market valuation then the purchasers will only gain if they can generate
synergies (operating economies or rationalisation). In an efficient market these synergies would be known and therefore
already incorporated in the price demanded by the target company shareholders.

The more efficient the market is, the less the opportunity to make speculative profit because it becomes impossible to consistently
outperform the market.

Evidence so far collected suggests that stock markets show efficiency that is at least weak form, but tending more towards semi –
strong form. In other words current share prices reflect all or most publicly available information about companies and their
securities.

The valuation of shares


Fundamental analysis
Fundamental analysis is based on the theory that share prices can be derived from a rational analysis of future dividends. If the
fundamental analysis of share values is correct, the price of any share will be predictable, provided that all investors have the same
information about a company’s expected future profits and dividends, and a known cost of capital.

Question
The management of Crocus are trying to decide on the dividend policy of the company.
There are two options that are being considered.
(a) The company could pay a constant annual dividend of 8c per share.

Market efficiency Page 2


(b) The company could pay a dividend of 6c per share this year, and use the retained earnings to achieve an annual growth of 3%
in dividends for each year after that.
The shareholder’s cost of capital is thought to be 10%.

Required:
Which dividend policy would maximise the wealth of shareholders, by maximising the share price?

Charting or Technical analysis


Technical analysis or chartists work on the basis that past price patterns will be repeated, therefore future price movements can be
predicted from historical patterns of share price movements in the past, and there are some patterns that continually re-appear.

Random walk theory


Random walk theory is consistent with the fundamental theory of share values. It accepts that a share should have an intrinsic
price dependent on the fortunes of the company and the expectations of investors. One of its underlying assumptions is that all
relevant information about a company is available to all potential investors who will act on the information in a rational
manner.

The key feature of random walk theory is that although share prices will have an intrinsic or fundamental value, this value will
be altered as new information becomes available, and that the behaviour of investors is such that the actual share price will
fluctuate from day to day around the intrinsic value.

Marketability and liquidity of shares


In financial markets, liquidity is the ease of dealing in the shares, how easily can the shares be bought and sold without
significantly moving the price? Share prices will be affected by marketability and liquidity of shares, availability and sources of
information, market imperfections and pricing anomalies, market capitalisation and investor speculation.

Behavioural finance
Speculation by investors and market sentiment is a major factor in the behaviour of share prices. Behavioural finance is an
alternative view to the efficient market hypothesis. It attempts to explain the market implications on the psychological factors
behind investor decisions and suggests that irrational investor behaviour may significantly affect share price movements. These
factors may explain why share prices appear sometimes to overreact to past price changes.

Market efficiency Page 3

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